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Monday, December 5, 2016

This Chart Shows Why the Fed Will Be Tightening Monetary Policy Soon

Will policymakers at the Fed raise interest rates at their December meeting? Wall Street oddsmakers increasingly think they will. One simple chart shows why.

The
chart tracks the economy’s progress toward the central bank’s target
of “stable prices and maximum employment.” The Fed’s rate-setting
Federal Open Market Committee (FOMC) has operated under this so-called dual mandate
since Congress amended the Federal Reserve Act in 1977. In recent
years, the Fed has interpreted “stable prices” to mean a rate of
inflation close to 2 percent per year, as measured by the annual change
in the price index for personal consumption expenditures (PCE). It
interprets “maximum employment” to mean the highest level that is
consistent with its 2 percent inflation goal, currently thought to be an
unemployment rate of about 4.8 percent.

We can use the two
components of the dual mandate to draw a bullseye that the Fed is aiming
for. Here is how things are going, seven years into the recovery from
the Great Recession. (All data shown in the chart are quarterly, except
for the last point, which shows the latest, still-incomplete data for
the fourth quarter of 2016—unemployment of 4.6 percent for November 2016
and PCE inflation of 1.5 percent for October.)

As
recently as the fourth quarter of last year, the Fed was missing the
inflation target by a wide margin on the downside and the unemployment
target by a smaller margin on the upside. Small wonder, then, that when
the FOMC raised interest rates at its December 2015 meeting, many
critics saw such an action as premature. That was especially true for
those who hold the orthodox view that 2 percent inflation is a not an
unconditional ceiling, but rather, a target that may acceptably be
exceeded for a time after a long period of below-normal price increases.

Over
the past year, though, the situation has changed considerably. As the
chart shows, over a five-year stretch starting in 2010, the economy
followed a path running generally from Northeast to Southwest, with
inflation and unemployment both falling. The slight uptick of inflation
from 0.3 percent in the first quarter of 2015 to 0.4 at the end of that
year did not, at the time, look like a real change of direction. Viewed
together with the most recent data, however, we can see that the
economy’s path may have begun turning toward the Northwest as long as a
year and a half ago.

In fact, for the first time in many years,
the pattern is starting to look like a traditional Phillips curve, along
which the inflation rate rises as the unemployment rate falls. As this earlier post
explained, the Phillips curve dominated thinking about monetary policy
in the 1960s and 1970s, but largely disappeared after the mid-1980s. Now
it seems to be making a comeback. If we are back in a Phillips curve
world, tightening interest rates now, even before inflation has hit the 2
percent target, makes more sense.

One reason for tightening now
is that interest rates do not affect the economy immediately. More than
half a century ago, Milton Friedman argued that monetary policy operates
with long and variable lags. When asked about lags during a press conference
in September of this year, Fed Chair Janet Yellen affirmed that
Friedman’s view was still “one of the essential things to understand
about monetary policy, and it has not fundamentally changed at all.” She
went on to say that she was “not in favor of a ‘whites of their eyes’
sort of approach.” Instead, she said,

Those of us
sitting around the table learned the lesson that if policy is not
forward looking, inflation can pick up to highly undesirable levels,
inflation expectations can be dislodged upward, and the consequence of
that can be that, endemically, higher inflation takes place, which is
very costly to reduce. And absolutely none of us want to relive an
episode like that. And so I believe, and my colleagues, that it is
important to be forward looking. We’re not going to make that mistake
again. [Edited for continuity.]

Market
developments since the November election are a second reason why the Fed
is likely to tighten sooner rather than later. Earlier in the fall,
some observers had worried that a win by the unpredictable presidential
candidate Donald Trump would plunge financial markets into an
uncertainty-driven slump, which the Fed would hesitate to aggravate with
a rate rise. Instead, the stock market has soared since the election,
housing prices have firmed, and at least some of the world’s dormant
commodity markets have turned upward. Warnings of potential bubbles have
replaced fears of an immediate slump.

One more reason that a rate
rise is likely is the expectation that a Trump presidency may shift the
relationship between monetary and fiscal policy. Since the expiration
of the Bush and Obama stimulus programs early in the recession, pressure
from Republican deficit hawks in Congress has kept fiscal policy tight.
As a result, the Fed has had to bear the entire burden of holding the
economy on its path to recovery, using quantitative easing and ultra-low
interest rates.

Now there is talk of massive tax cuts combined
with a bipartisan agreement on an expanded program of infrastructure
spending. If Congress does substantially loosen fiscal policy just as
inflation and unemployment are finally reaching their target values, the
Fed will have to lean hard in the other direction to maintain balance
in overall macroeconomic policy.

The bottom line: No wonder observers now peg the chance of an imminent interest rate increase at better than 90 percent.

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